VAT levy could help with other taxes

Farooq Tirmizi May 10, 2010

KARACHI: The government may be getting much more than just revenues when it begins to levy the Value Added Tax (VAT) beginning July 1, 2010.

It may finally have created an incentive for businesses to declare their full revenues when filing for taxes. Left to its own devices, the government of Pakistan would never have imposed the tax, if only to avoid the inevitable protests and declarations of “rejection” from all and sundry trade associations. But the absolute insistence of the International Monetary Fund (IMF), which is currently the only sugar-daddy the government can turn to right now, tipped the balance in the favour of such an imposition.

However, a key area where the government seems to have made a mistake is to explain how the Value Added Tax works. Unlike the current General Sales Tax, which is only levied at the retail level, the Value Added Tax is levied at all stages of production. For example, a car has several stages of production. In the first stage, a steel mill buys iron ore to make steel. VAT is levied on the difference between the cost of the iron ore and the price at which the mill sells its steel.

However, the way VAT normally works in other countries is that the steel mill pays the VAT on the full price of its product and then applies to the government to get a refund for the cost of its raw materials. The same procedure applies to the next stage, when the car parts manufacturer buys the steel and makes the car parts, paying the tax on the full price of its product and then later applying for a refund. The car manufacturer then does the same thing at the final stage of production.

As may be evident from the above, each manufacturer has an incentive to be truthful about how much they are selling and at what price they are both buying and selling. Any company that over-declares their costs or under-declares their revenues would be more easily caught since companies both before and after it in the production chain would be reporting the same figures as well. Any discrepancy would be easily detectable, especially if the government makes the process entirely automated.

Companies would have a hard time getting each other’s collaboration in tax evasion because over-declaring costs decreases the buyer’s tax liability but increases the seller’s taxes. The incentive not to cheat is deeply rooted in this tax. Twenty-nine of the 30 countries that make up the richcountry organisation, the OECD, impose the VAT with the degree of tax evasion estimated at 4 per cent to 17 per cent, according to The Economist, meaning that it is not entirely fool-proof.

But it is certainly much better than what exists right now in Pakistan. If most companies are declaring their revenues and expenses with relative accuracy, the government can have a more accurate estimate of how much they should owe in income taxes. The problem, of course, is that the government has yet to declare the precise details of how the tax will be levied. More importantly, Pakistanis are a creative bunch when it comes to devious activities.

And the levy of this tax will still not get rid of the problem of corruption and inefficiency at the FBR itself. Nonetheless, should the government choose, it has a very powerful tool available at its disposal in the VAT.

Published in the Express Tribune, May 11th, 2010.


Meekal Ahmed | 13 years ago | Reply This is a very good article which sets out the operational facts of the VAT very well. Of course in any tax system there will be leakages. The key is to keep these leakages within acceptable limits, something we have not done so far. As for the sugar-daddy, the IMF. It is after all called the "Lender of Last Resort" for countries in economic distress. When no one will give you a dime, the IMF will but at a price. The sugar-daddy has always been around to bail out our profilgacy. Maybe that is the problem. We KNOW we will be bailed out each time no matter how badly we screw up. And there have been some real screw up's in the past two decades or so with Pakistan turing to its sugar-daddy time and again. In IMF jargon, Pakistan is categorized as a country which is a "Prolonged User" of IMF resources. Economists call this "moral hazard". If you know there is someone who will save your skin you are inclined to take risks and do dumb things.
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